Inflation deflation and purchasing power Outline q Inflation

Inflation, deflation and purchasing power Outline: q. Inflation and deflation q. Disinflation. Stagflation and slumpflation q. Theories on inflation q. Inflation and unemployment q. Measurement of inflation/deflation q. Purchasing power parity q. Balassa-Samuelson effect

Price stability The average price of goods and services = price level. Today, all central banks (CBs) are concerned to ensure price stability. Alan Greenspan: Ø inflation is so low and stable over time that it does not materially enter into the decisions of households and firms. European Central Bank: Ø a year-on-year increase in the inflation rate for the euro area of below 2%. Price stability’s benefits – high levels of economic activity and employment by: Ø improving the transparency of the price mechanism - people can make well-informed consumption and investment decisions and allocate resources more efficiently; Ø reducing inflation risk premia in interest rates - this reduces real interest rates and increases incentives to invest; Ø avoiding unproductive activities to hedge against the negative impact of inflation or deflation; Ø preventing an arbitrary redistribution of wealth and income as a result of unexpected inflation or deflation; Ø contributing to financial stability.

Inflation – definition Barro and Grilli: Ø the increase in the general level of prices of goods and services in a given economy over a period of time. Keynes: Ø inflation is generated by a surplus of demand of goods and services which the economy cannot satisfy, so the result is an increase in prices. Parkin and Bade: Ø an upward movement in the average level of prices. Friedman: Ø inflation is always a monetary phenomenon caused by high rates of growth in the money supply. !!!!! inflation = the increase in the general price level increase in amount of money needed to purchase same amount of goods and services decrease in purchasing power (PP) = one unit of money buys less goods and services.

Average Inflation Rate Versus Average Rate of Money Growth for Selected Countries, 1992– 2002 Source: Mishkin, 2004, pg. 11 The countries with the highest inflation rates = the ones with the highest money growth rates.

Inflation – causes Causes: Ø a growth in money supply – Milton Friedman (a Nobel laureate in economics): “Inflation is always and everywhere a monetary phenomenon”: § financing the government deficit by money creation – by printing money (monetizing the debt); § credit expansion to finance unproductive sectors; Ø an increase in aggregate demand; Ø a decrease in aggregate supply; Ø increases in taxes; Ø increases in resources costs; Ø depreciation of domestic currency; Ø increases in imports costs; Ø increases in wages faster than increases in productivity.

Inflation – consequences Negative effects: hurts people on fixed incomes (the retired): Ø because of the redistribution of wealth and income hurts savers and lenders (helps debtors): Ø because real interest rate can be negative hurts people who contract to be paid in the future: Ø because of the money depreciation makes financial decision making more difficult: Ø distorts relative prices. Ø inefficient allocation of resources. 1. discourage economic growth 2. hedging = avoiding or reducing a loss by taking a counterbalancing action: § buy gold, real estate or some other store of value besides money

Inflation – measure to control Monetary policy: CB can take some measures to reduce or prevent inflation through the reduction of money supply growth, such as: Ø the increase of interest rate, Ø the reduction or limitation of the volume of credits, Ø the increase of minimum reserve rate, Ø the selling of the government securities to commercial banks, etc. Fiscal policy: aims to reduce budgetary deficit through: Ø the reduction of government spending or Ø the increase of government income (taxes), which reduces the aggregate demand. Income policy: prices and wages control and varies from “voluntary” wages and prices guidelines to mandatory control like wages/prices freezes: Ø government can impose fees to those firms that raise prices/wages more that the control allows. Ø government can also subsidize the prices of some goods and apply an indexation of wages.

Deflation – definition Barro and Grilli: a decrease in the general level of prices of goods and services in a given economy over a period of time. Parkin and Bade: a downward movement in the average level of prices; the boundary between inflation and deflation is price stability. Classical economics: a decrease in the money supply. = a major problem because of the potential of a deflationary spiral: decreases in prices lead to lower production, which in turns leads to lower wages and demand, which leads to further decreases in prices. deflation = the opposite of inflation !!! general level of prices decrease the value of money increases: - one unit of money buys more goods and services.

Deflation – causes and consequences Causes: increase in the aggregate supply of goods decrease in money supply decrease in aggregate demand for goods increase in money demand supply of goods increases faster then money supply. Negative effects: great depression uneven fall in prices: business failures job losses hurts debtors hurts property-owners

Deflation – measure to control Fiscal and monetary measures to control the deflation: Ø reduction in taxation – to increase the purchasing power of the people Ø redistribution of income to increase aggregate demand – from the rich to the poor Ø repayment of old public debt – to increase the purchasing power Ø subsidies – to induce the businessmen to increase investment Ø public works programme – to increase expenditure in public sector Ø deficit financing – by printing new money Ø reduction in interest rate – to stimulate investment and thereby expand economic activity Ø credit expansion – to promote business and industry in the country Ø foreign trade policy – to increase exports and reduce imports Ø regulation of production – to avoid the problem of over-production Fiscal policy alone or monetary policy alone is not sufficient to check deflation in an economy.

Disinflation. Stagflation and slumpflation Disinflation: Ø is a decrease in the rate of inflation. Stagflation (a combination of the two words stagnation and inflation): Ø a contraction or stagnation of output combined with rise in the price level; Ø declining output led to a growing unemployment; high inflation rate + low or zero economic growth + high unemployment Ø happened to a great extent during the 1970 s, when world oil prices rose dramatically, causing sharp inflation in developed countries. Slumpflation (a combination of the two words slump and inflation) Ø economic depression is combined with increasing inflation. high inflation + negative growth + high unemployment Stagflation and slumpflation have similar features, but the slumpflation is a more critical state of economy.

Stagflation – causes and measure to control Causes: § modern economists – the main cause of stagflation is the reduction in aggregate supply – may be due to the following factors: Ø reduction in labor supply; Ø increases in taxes; Ø increases in resources costs. Measures to control of stagflation: Ø the should make every effort that minimum wages are not raised during stagflation. Ø the increase in wages should be linked with increase in productivity. Ø the personal and business taxes should be reduced to bring down the costs of goods. Ø the government itself should take up development programs to create jobs in the country.

Types of inflation (I) By intensity – no strict delimitation of ranges of intensity in price increase: Ø Hyperinflation: is the most extreme inflation phenomenon, with yearly price increases of three-digits percentage points; it exceeds 50% monthly, although normal inflation is reported per year. Ø Galloping (jumping) inflation: prices rise by more than 10%, (double-digit inflation rate). Ø Moderate inflation: is a combination between creeping and walking inflation; it happens when prices rise by less than 10% per year (single digit inflation rate). Ø Walking inflation: when prices rise by more than 3%, but less than 10% per year. Ø Creeping (mild or low): prices rise by not more than (i. e. up to) 3% per year. Ø Price stability: when prices rise 2% or less per year; it is actually beneficial to economic growth.

Types of inflation (II) By causes: ü Monetary inflation: inflation caused by a sustained increase in the money supply of a country. ü Demand-pull inflation: inflation caused by increases in aggregate demand due to increased private and government spending. ü Cost-push inflation: inflation caused by drops in aggregate supply due to increased prices of inputs. ü Imported inflation: inflation caused by the increase of imports’ prices or depreciation of domestic currency. ü Built-in inflation: inflation caused by the price/wages spiral, because the workers try to keep their wages up with prices and the employers passing higher costs on the consumer as higher prices.

Types of inflation (III) By anticipations: § Anticipated inflation: ü The inflation rate that we believe to occur. § Unanticipated inflation: ü Inflation at a rate that comes as a surprise. § Inflation affects people differently: ü Anticipated inflation: Ø People can protect against it. ü Unanticipated inflation: ü Creditors lose; ü Debtors gain.

Theories on inflation Quantity Theory of Money: excessive money supply growth can cause inflation. Monetary Theory of Inflation: “inflation is always and everywhere a monetary phenomenon”. Demand-pull Theory: “too much money purchasing too few goods”. Cost-push Theory: if costs rise too fast, companies will need to put prices up to get the same value for their products. Structural Inflation Theory: inflation caused by structural factors Rational Expectations Theory: there is a clear link between people’s price expectations and the level of inflation. Wage-price spiral: cost-push and demand-pull inflation can interact to cause a wage-price spiral.

Quantity Theory of Money The classical economists view of inflation revolved around this theory. It imply states: changes in the general price level are determined primarily by changes in the quantity of money in circulation. This theory derived from the Fisher’s Exchange Equation : M*V = P*Y Where: M – money supply; V – velocity of money; P – the average price level; Y – real income. Classical economists suggest that: Ø V would be relatively stable; Ø Y would always tend to full employment (would be stable) Conclusion: Ø increases in money supply would lead to increases in price level, which could cause inflation. By controlling the money supply, we would be able to control the inflation.

Monetary Theory of Inflation Monetarism refers to the followers of M. Friedman who hold that “only money matters”, and as such monetary policy is a more potent instrument than fiscal policy in economic stabilization. According to the monetarists, the money supply is the dominate determinant of: Ø both the level of output and prices in the short run, Ø and of the level of prices in the long run. The monetarists emphasized the role of money. Modern quantity theory led by Milton Friedman holds that: Ø “inflation is always and everywhere a monetary phenomenon that arises from a more rapid expansion in the quantity of money than in total output”. The monetarists employed the familiar identity of exchange equation of Fisher.

Demand Pull Theory John Maynard Keynes (1883 -1946) and his followers emphasized the increase in aggregate demand as the source of demand-pull inflation. The aggregate demand comprises: Ø consumption; Ø investment; Ø government expenditure. When aggregate demand exceeds the value of aggregate supply at the full employment level, the inflationary gap arises. the larger the gap between them, the more rapid is the inflation. The causes of aggregate demand growth can be: ü Consumers are spending more because interest rates have fallen, taxes have been cut, or there is a greater level of consumer confidence. ü Firms are investing more in the expectation of future economic growth. ü Government is increasing expenditure on defense, health, education etc.

Cost Push Theory Cost-push inflation appears when costs increase independently of aggregate demand. The sources of rising costs are: Ø Wages: trade unions gain more power, being able to push wages up: § the rise in wages is more rapidly than the productivity of labor. Ø Profits: firms raise the price of their products to offset the rise in labor and cost of production to earn higher profits. ü Imported inflation: firms increase prices to pay the higher raw materials or semi-finished products costs, caused by: exchange rate changes, commodity price changes or external shocks. ü Exhaustion of natural resources: if resources run out, their price will inevitably rise, increasing the firms’ costs and pushing up prices. ü Taxes: changes in indirect taxes (taxes on expenditure) increase the cost of living and push up prices of products in shops.

Structural Inflation Theory Is an explanation of inflation prevailing in developing countries in terms of structural features of their economies: Ø are structurally underdeveloped; Ø highly fragmented due to the existence of market imperfections and structural rigidities of various types; Ø rapid and faster growth of the service sector that is related to population growth and immigration. These structural imbalances and rigidities of economy: shortages of supply relative to demand in some sectors under-utilisation of resources and excess capacity due to lack of demand in other sectors Structuralism hold the view that inflation is necessary with growth: Ø as the economy develops, rigidities arise which lead to structural inflation.

Rational Expectation Theory Economic agents form their macroeconomic expectations “rationally” based on all past and current relevant information available. If the monetary authority announces a monetary stimulus in advance, people expect that prices are being rise: Ø this fully anticipated monetary policy cannot have any real effects even in the short-run; Ø the CB can affect the real output and employment only if it can find a way to create a “price surprise”. Ø if a policymaker announces a disinflation policy in advance, this cannot reduce prices if people do not believe it. price expectations are closely related to the necessity of policy credibility and reputation for successfully policy implementation. People take into account their expectation in their wage claims: Ø if inflation is expected, then people will claim a real wage increase; Ø this will increase firms’ costs, which can in itself cause inflation.

Wage-price spiral It is most likely to happen when the economy is nearing its potential, near to full employment: Ø any increase in demand implies that the firms need to expand output to meet the demand. If firms are at or near their full capacity, they will seek to attract resources to expand – labor being part of these resources. To employ skilled labor, firms have to offer more attractive packages to convince people to move from one job to another thus raising their costs. Employees will want to be compensated for the higher prices, and they will push for higher wages. The higher wages push up costs again, and so firms push up prices again and so on…: the wage-price spiral is created. The wage-price spiral can be very difficult to get rid of, as people quickly build the increased level of inflation into their expectation.

Inflation and unemployment – Phillips curve The Phillips curve is a relationship between unemployment and inflation discovered by Professor A. W. Phillips (1958), based on the observations of unemployment and changes in the wage levels from 1861 to 1957: Ø there appeared to be a trade-off between unemployment and inflation: § any attempt by governments to reduce unemployment was likely to lead to increased inflation. an inverse relation between inflation and unemployment In the 70 s the curve appeared to break down as the economy suffered from unemployment and inflation rising together (stagflation). Friedman (1968) developed the expectations-augmented Phillips curve: Ø the Phillips Curve was only applicable in the short-run; Ø in the long-run, inflationary policies will not decrease unemployment: § only a single rate of unemployment (the NAIRU – non-accelarating inflation rate of unemployment or "natural" rate) was consistent with a stable inflation rate.

Measurement of inflation Inflation is measured by calculating the percentage rate of change of a price index called the inflation rate. This can be calculated for many different price indexes, including: ü Consumer price index (CPI) ü Harmonized index of Consumer Prices (HICP) ü The GDP deflator ü Producer price index ü Core inflation ü Purchasing Power Index Price indexes are typically constructed to have relative value of 100 (or 1. 00) in a specific year called base year. Inflation is measured by the percentage increase in the price level per year. Similarly, a negative rate of inflation is referred to as deflation.

Consumer price index (I) CPI is an index number measuring the average price of consumer goods and services purchased by household. It is a measure of the average change over time in the prices paid by consumers for a basket of consumer goods and services. It gives a measure of headline inflation. A basket of goods and services is composed of 8 to 12 major groups: ü Foods and beverages ü Housing ü Apparel ü Transportation ü Medical care ü Recreation ü Education and communication ü Other goods and services

Consumer price index (II) CPI: Ø includes various fees and taxes which are directly associated with the prices of specific goods and services; Ø excludes taxes which are not associated with the purchase of consumer goods and services: ü investment items (stocks, bonds, real estate, and life insurance) - these relate to savings and not day-to-day consumption expenses; ü savings; ü visitors’ expenditure within country; ü illegal expenditures; ü rural population may be excluded. ü certain groups such as the very rich or very poor may be excluded. CPI is the best measure of purchasing power of population, because it includes indirect taxes and taxes on consumption.

Harmonized index of consumer prices (I) HICP is an indicator of inflation and price stability for the ECB. It is a weighted average of price index of member states in order to measure CPI for the entire Eurozone. ECB uses three key HICPS: ü The Monetary Union Index of Consumer Prices ü The European Union Index of Consumer Prices ü The national HICPs. There is no uniform basket applying to all the EU countries: Ø the distribution of purchases of goods and services and the nature of some of the goods and services vary from country to country; Ø the HICPs is based on the prices and expenditures which are representative in each country, and not on average ‘euro-basket’. HICP for a country should: Ø include the consumption expenditures made by foreign visitors; Ø exclude the expenditures made by residents while visiting the foreign (non EU) country.

Harmonized index of consumer prices (II) There can be substantial differences between the HICPs and individual national CPIs as national CPIs use their own national methodology. The main reason for these differences is: ü The different structure of weights due to the different coverage of the HICP and of the CPI in respect of the treatment of the consumption of the non-residents on the territory of the country. HICP covers this consumption, but CPI does not. HICP differs from the United States CPI in two main aspects: ü HICP incorporates rural consumers into the samples, while the US maintains a survey strictly based on the urban population. ü US CPI calculates “rental-equivalent” costs for owner-occupied housing, while the HICP considers such expenditure as investment and excludes it.

CPI versus HICP CPI is based on “national criterion”: Ø CPI includes the consumer expenditure made by residents in the domestic country and the expenditures made by residents while visiting the foreign country. HICP is based on “internal criterion”. Ø HICP includes the consumer expenditure made by both residents and foreign visitors in the domestic country. These two different criteria can lead to two different results in term of inflation rate.

The GDP deflator GDP represents the total value of all final goods and services produced within an economy during of specified period: GDP = [consumption + gross investment + government spending + (exports – imports)] GDP deflator is a measure of the change in prices of all new, domestically produced, final goods and services in a economy. GDP deflator measures the difference between the real GDP and nominal GDP: GDP deflator = (Nominal GDP/Real GDP)*100 It is the broadest measure of prices.

Producer price index (PPI) PPI measures average changes in prices received by domestic producers for their output. PPI differs from the CPI in that price subsidization, profits and taxes may cause the amount received by producers to differ from what the consumer paid. There is also typically a delay between an increase in PPI and any resulting increase in the CPI. Producer price inflation measures the pressure being put on producers by the costs of their raw materials. This could be “passed on” as consumer inflation, or it could be absorbed by profits, or offset by increasing productivity. PPIs for: Ø Foodstuffs Ø Intermediate goods Ø Finished goods

Core inflation (underlying inflation) is a measure of inflation which excludes certain items that face volatile price movements (e. g. foods and energy). Core inflation eliminates products that can have temporary price shocks because these shocks can diverge from the overall trend of inflation and give a false measure of inflation. It represents the long run trend in the price level: Ø in measuring long run inflation, transitory price changes should be excluded. Core inflation is thus intended to be an indicator and predictor of underlying long-term inflation. Core inflation is most often calculated by taking the CPI and excluding certain items from the index, usually energy and food products.

Purchasing power (PP) index Purchasing power of money represents the quantity of goods and services that can be bought with one unit of money. If prices are increasing, the purchasing power of money are decreasing. By contrast, if prices are decreasing, the purchasing power of money are increasing. PP index is the inverse of the price index: PP index can serve to determine the degree of depreciation or appreciation of a currency.

Purchasing power parity (PPP) (I) a theory: exchange rates between currencies are in equilibrium when their PP is the same in each of the two countries. the exchange rate between two countries should equal the ratio of the two countries’ price level: when a country’s domestic price level is increasing, that country’s exchange rate must depreciate in order to return to PPP. The basis of PPP is the “law of one price”: Ø abstracting from transportation costs, taxes and tariffs, any good that is traded on world markets must sell for the same price in every country, when prices are expressed in a common currency. Example: Ø a jacket that sells for 225 RON in Bucharest should cost 50 Euro in Rome when the exchange rate is 4. 5 RON/EUR. Ø if the price of jacket in Bucharest is only 185 RON, consumers in Rome would prefer buying the jacket in Bucharest at the price of 41 Euro.

Purchasing power parity (PPP) (II) If this process (called “arbitrage”) is carried out at a large scale, we should expect to see three things happen: ü Italian consumers desire RON in order to buy jackets in Romania: RON will appreciate against euro. ü The demand for jackets sold in Italy decreases: price Italian retailers charge goes down. ü The demand for jackets sold in Romania increases: price Romanian retailers charge goes up. the exchange rates and the prices in the two countries to change such that we have PPP and the goods have again the same prices. PPP describes the long run behavior of exchange rate. There are three limitations with the “law of one price”: 1) transportation costs and other transaction costs can be significant; 2) there must be competitive markets for the goods and services in both countries; 3) this law only applies to tradable goods.

Absolute PPP vs. relative PPP Absolute PPP refers to the equalization of price levels across countries: ü The exchange rate between Romania and Italy is equal to the price level in Romania divided by the price level in Italy. ü Assuming that : Ø the price level ratio implies a PPP exchange rate of 4. 3 RON/EUR Ø and if today’s exchange rate is 4. 5 RON/EUR ü PPP theory: the RON will appreciate against Euro and the Euro will depreciate against RON to equalize the PPP exchange rate. Relative PPP refers to the rates of changes in the price levels = inflation rate: ü The rate of appreciation of a currency is equal to the difference in inflation rates between the foreign and the home country. ü Example: if Romania has an inflation rate of 3% and Italy has an inflation rate of 1%, the RON will depreciate against the Euro by 2% per year.

Real versus nominal magnitudes The word “nominal” indicates that values are measured using current prices: Ø nominal value = value expressed in current price The word “real” indicates that values are measured in terms of fixed prices: Ø real value = value expressed in PP, adjusted for inflation Example: Ø a nominal income of 30, 000 in 2014 Ø a nominal income of 15, 000 in 1996 Ø all prices doubled between 1996 and 2014 30, 000 buys the same amount of goods because prices have doubled. A real income measure indicates that the income in terms of the goods it can buy is the same: Ø measured in 1996 prices, the 30, 000 of nominal income in 2014 turns out to be only 15, 000 of real income. Because real variables measure quantities in terms of real goods and services, they are of more interest than nominal variables.

Inflation and interest rates. Fisher effect Nominal interest rate: Ø the market interest rate expressed in today’s money Real interest rate: Ø interest rate that is adjusted to inflation; Ø reflects the true cost of borrowing; Ø is more accurately defined by the Fisher equation: Ø the nominal interest rate equals the real interest rate plus the expected rate of inflation (for small values of and ) A more precise formulation of the Fisher equation is: because:

Balassa-Samuelson effect Generally, the tradable goods sector has a higher productivity growth than the non-tradable goods sector: Ø the wages are bigger in the former than in the latter sector. Given that wages are expected to be approximately the same across sectors, faster productivity growth in the tradable goods sectors pushes up wages in non-tradable goods sectors. To cover the increased costs with wages, the employees incorporate it in prices of non-tradable goods: Ø an increase in the relative prices of non-tradable goods. increases in the prices of non-tradable goods exceed the increases in the prices of tradable goods, generating inflation. The higher the differential productivity growth between the tradable and non-tradable goods sectors is, the higher the inflation will be. If productivity growth in one country exceeds productivity growth in another country, overall inflation will be higher in the former.